Ideas for Intelligent Investing

Li Lu’s Tribute to Charlie Munger

Li Lu has garnered a lot of attention in the past couple months as speculation swirled that he was on the short list of candidates to manage Berkshire Hathaway’s investments after Warren Buffett dies or steps down. Speculation started when Charlie Munger mentioned at the last Berkshire Hathaway shareholder meeting that one of the candidates returned 200% in 2009. Some thought that Munger could be referring to Lu because of his highly successful investment in BYD, a Chinese manufacturer of rechargeable batteries and automobiles.

We’ve since learned that Lu manages money for Charlie Munger.

Here is a tribute that Lu wrote about Charlie Munger who has become his mentor and friend. There are a lot of valuable lessons in the article. I particularly like Lu’s understanding of market volatility. Conventional wisdom holds that volatility is equal to risk; this is grounded in efficient market theory. Why? Because if the theory is true then lower prices always mean that there has been a reduction in the underlying value of the company.

Lu on the other hand views risk as the possibility that you will suffer a permanent loss of capital. He uses market volatility as an opportunity to buy cheap stocks.

Here’s the article. It appeared in a magazine called Chinese Entrepreneur. Please note that the translation from Chinese to English is less than perfect.

Twenty years ago, as a young student coming to the United States, I couldn’t have imagined having a career in investments and would never have thought that I’d be fortunate enough to meet with the contemporary investment guru, Mr. Charlie Munger. In 2004, Mr. Munger became my investment partner and has since become my lifelong mentor and friend — an opportunity I would have never dared to dream about.

I graduated from Columbia University in 1996 and founded my investment company in 1997, thus starting my professional investment career. Till this day, the vast majority of individual investors and institutional investors still follow investment philosophies that are based on “bad theories.” For example, they believe in the efficient market hypothesis, and therefore believe that the volatility of stock prices is equivalent to real risk, and they place a strong emphasis on volatility when they judge your performance. In my view, the biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. Not only is the mere drop in stock prices not risk, but it is an opportunity. Where else do you look for cheap stocks? But I found that while, on the surface, famous fund managers appear to accept the theories of Buffett and Munger and show great respect for their performance, they are in actual practice the exact opposite because their clients are also the exact opposite to Buffett and Munger. They still accept the theories that say “volatility is risk” and “the market is always right.”

Charlie and I first met at a mutual friend’s house while I was working on investments in LA after graduating from college. The first impression he gave me was “distant” — he often appeared to be absent-minded to the presence of his conversation partners and was, instead, very focused on his own topics. But this old man spoke succinctly; his words full of wisdom for you to mull over.

Seven years after we’ve known each other, at a Thanksgiving gathering in 2003, we had a long heart-to-heart conversation. I introduced every single company I have invested in, or researched, or am interested in to Charlie and he commented on each one of them. I also asked for his advice on the problems I’ve encountered. Towards the end, he told me that the problems I’ve encountered were practically all the problems of Wall Street. The problem is with the way the Wall Street thinks. Even though Berkshire Hathaway has been such a success, there isn’t any company on Wall Street that truly imitates it. If I continue on this path, my worries will never be eliminated. But if I was willing to give up this path right then, to take a path different from Wall Street, he was willing to invest. This really flattered me.

With Charlie’s help, I completely reorganized the company I founded. The structure was changed into that of the early investment partnerships of Buffett and Munger (note: Buffett and Munger each had partnerships to manage their own investment portfolios) and all the shortcomings of the typical hedge funds were eliminated. Investors who stayed made long-term investment guarantees and we no longer accepted new investors.

Thus I entered another golden period in my investment career. I was no longer restricted by the various limitations of Wall Street. The numbers still fluctuate as before, but eventual result is substantial growth. From the fourth quarter of 2004 to the end of 2009, the new fund returned an annual compound growth rate of 36% after deducting operating costs. From the inception of the fund in January 1998, the fund returned an annual compound growth rate in excess of 29%. In 12 years, the capital grew more than 20 folds.

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